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The rock and a hard place of the Fed's short and long term interest rate policies were very evident in the net interest results reported by Annaly Capital Management (NLY) for the 2012 third quarter. The net interest spread for the quarter was less than half of the spread earned during the 2011 third quarter and, to my mind, shockingly lower than the 2012 second quarter interest earnings.

For the quarter, Annaly Capital reported an annualized interest rate spread during the quarter of 1.02%. For the 2011 third quarter, the spread was 2.08%, and the interest spread over the 2012 second quarter was 1.54%. Rates were a little better at the end of the quarter, with the portfolio earning a net spread of 1.24% compared to 1.59% at the end of the second quarter.

Avg. YieldAvg. CostNet Spread
Q3 20122.54%1.52%1.02%
Q2 20123.04%1.50%1.54%
Q3 20113.71%1.63%2.08%

Cash Flow for Dividends

Annaly reported an adjusted net income for the quarter of $449.8 million or $0.45 per share. Of this net income, realized portfolio gains were $142.2 million, leaving net interest earnings of $307.6 million.

Annaly declared a $0.50 dividend for the third quarter down from the $0.55 paid in the second quarter. The Q3 10-Q has not yet been published, but using data from the previous 10-Q and extrapolating for share count and dividend rate changes, I estimate the total dividends paid in the third quarter were $485 million. Net interest income for the quarter covered just 63% of the dividends paid.

Market Outlook for Mortgage REITs

The Fed's QE3 purchases of mortgage securities has very quickly sped up the interest rate squeeze on the mortgage REIT companies. In early September I discussed how the companies cannot beat the math of a flattening yield curve in my article, mREITs: Irrefutable Math Portends Interest Rate Problems. To combat the loss of interest income, the mREIT companies are selling off bonds for capital gains to boost quarterly income. This problem affects all agency mREIT companies. American Capital Agency (AGNC) also covered just 65% of the recent dividend with interest earnings.

Without selling bonds for capital gains, Annaly could afford a 30 cent quarterly dividend. Unfortunately, when bonds are sold, the proceeds get reinvested at the sub-2% yield of current MBS. Yet if the company tries to hold onto bonds, prepayments suck away bond premiums without any return on investment.

Annaly Capital has new leadership at the helm and it will be interesting to see how the current market issues are handled over the next few quarters. Also of interest is the answer to what would the market do to the share price of a mREIT which took a conservative stance and cut the dividend rate down close to the level of net interest earnings. I think we will all get a chance to find out over the next few quarters.

NLY Chart

NLY data by YCharts

Source: Annaly Capital Management Sees Interest Spread Drop By Half Since Last Year